What is working capital and how do you manage it?

Running a business meaning juggling the money coming in against the money going out.

This process is known as cash flow, but cash flow isn’t the whole picture.

You also need to have a grasp of what your usable assets are at any one time, to ensure that you can meet all your financial obligations. This means understanding working capital.

Here you can find out how you can improve your working capital through effective management of it.

What is working capital?

Working capital is the difference between your company’s assets and its current liabilities.

Your assets include not just the money that you have in your bank account or any money owed by clients, but your inventory of raw materials or stock of products. Your liabilities include your debts, unpaid bills or accounts payable.

Working capital is an important indicator of the efficiency of your operations, and a gauge of how healthy your business will be in the long-term.

If you seem to be lurching from one liquidity crisis to another and always scrambling to find available funds, you should take a look at your working capital.

If your assets do not at least match your liabilities, you are in danger of failing to pay your debts and going bankrupt.

Financial analysts see a worsening working capital situation as an indication that there is something wrong with your business, which could in turn affect your ability to secure loans or investments.

Why is working capital important?

Having more assets than you owe may seem like common sense, but the complexity of keeping a business going day to day can make this balancing act more difficult.

If you are coming to the end of each month with just enough to cover your expenses, bills and wage costs, it could be easy to assume that you are in a stable business position.

But what happens if you suddenly need to replace a piece of equipment, cover legal costs or carry out some expensive repairs, or what if you lose an important client? That perception of stability can quickly give way to uncertainty.

Working capital is useful barometer of how healthy your business is, and how resilient.

Every business will face periodic challenges such as a drop in sales, new competition in the marketplace or economic instability.

If you have good working capital, you will be better prepared to weather these storms, either by liquidating some of your assets or by trying to secure a new loan. 

If you are constantly having to put out fires, you are not going to be able to dedicate as much of your time to growing your business.

Establishing good working capital and being careful to maintain it helps to increase the stability of your operations. Financial uncertainty is also a cause of stress, so taking some steps to mitigate it will benefit you personally as well as professionally.

How to calculate working capital

To calculate your working capital, simply subtract your current liabilities from your current assets:

Working capital = current assets - current liabilities

Current assets include items such as cash, accounts receivable, and inventory.

Current liabilities, on the other hand, encompass obligations like accounts payable, short-term loans, and other debts.

How is working capital different from cash flow?

Working capital is a snapshot of your current assets versus your liabilities, but it doesn’t reveal much about how this money is actually moving around.

This is where cash flow comes in. Your cash flow statement shows you exactly how money is coming into your business, and how and when it moves back out again.

Therefore, understanding your cash flow will help you predict and manage your working capital over the long term.

Cash flow analysis can show you where resources are being wasted or tied up for an unnecessarily long time.

Retailers, for instance, may damage their working capital by spending too much money on stock items that take ages to sell, and could free up some assets by buying less of this kind of product and more quick-sale items.

Similarly, you could decide to lease rather than buy equipment, which could save you from having to take on a large upfront cost.

Common working capital mistakes

If you’ve been seeing the state of your working capital decline over a few quarters, or if your business seems prone to liquidity crises, a couple of factors may be to blame.

Firstly, you may not have been properly accounting for the interest you’ve accrued. If your growth projections for a year were over 10 per cent, it can make sense to take out a loan at 8 per cent interest.

However, if your growth turns out to be just 6 per cent (say) then you’ll have less working capital than you forecast.

Secondly, you may own too much equipment. Leasing equipment that you use only semi-regularly can be a great way of decreasing your liability and giving you more assets to play with.

Leasing turns your equipment into a standard monthly cost rather than one large upfront one followed by unpredictable bouts of maintenance.

You also don’t have to pay to replace aging or inferior equipment, expenses which can often be unexpected.

Improving your working capital management

If you’re able to identify the causes that are impacting your working capital, you can start figuring out what steps to take in order to improve the situation.

There are really only two ways to do this: reduce your liabilities or increase your liquid assets. One option could be more appropriate than the other, depending on your business.  

Here are a few steps to help you improve working capital:

Bring your expenses down

A common cash flow issue for small businesses is losing control of expenses.

You could contract certain workers instead of hiring them as employees, or you could try to conduct business meetings over the internet rather than in person.

Sort out your payment cycles

If you’re always waiting for customers to pay their invoices, you may find yourself having to pay your suppliers before you’ve received your money.

You could try to agree a shorter payment cycle with your customers, and get better at credit control.

Hold less stock

Whether you hold a product for a year or a day, it is listed on your balance sheet as an asset.

If a product is going to sit unsold in storage for months at a time, it is essentially sapping your liquidity by locking your money up until it is sold.

Try to optimise your stock so that you hold fewer of the items that typically take longer to sell.

You could also try to work with suppliers that can ship products to you on demand rather than in predefined batches.

Getting to grips with your working capital is the key to making your business more resilient in the face of unexpected challenges and more stable on a daily basis.

It also makes the task of running your company less stressful. An experienced accountant can help you manage your working capital more effectively.